Air Canada (TSX:AC) stock jumped 3.5% to trade at an altitude of above $20. Behind the rally is the airline’s revised earnings outlook for 2023. It is the first time since the pandemic that the airline has raised its outlook. Does this hint that the worst is over for Air Canada? Is the airline on the path of a recovery rally, or does more volatility lie ahead before the stock sets on the long-term growth path?
Air Canada’s recovery: Phase one
After the dreadful pandemic altered the world for airlines, the recovery was a given in 2022 on the back of pent-up demand and the easing of Covid restrictions. Oil prices were bound to rise from the record low of US$35/barrel as demand surged. The airline also saw a recovery, as it operated at 87% of the pre-pandemic capacity in 2022.
Airlines operate on wafer-thin margins where the cost per seat plays a significant role. There is a fixed operating cost of flying a plane from one destination to another. The profitability depends on how many seats the airline can fill in every flight while keeping its other costs low.
Three things stopping Air Canada’s recovery
Air Canada ordered new planes and increased long-haul flights to meet demand. But three events stopped its recovery:
- The Russia-Ukraine war pushed oil prices above US$100 and changed the cost environment for the airlines. Fuel cost per litre rose to $1.3 in 2022 from $0.75 in 2021. Air Canada passed on the fuel cost to passengers, but its operating costs were still greater than revenue.
- The rising oil price strengthened the U.S. dollar, and the exchange gap widened. AC’s foreign exchange loss ballooned to $732 million in 2022 from $52 million in 2021.
- Interest rates surged from 0.25% in February 2022 to 4.5% in January 2023 to control inflation arising from high oil prices. With a net debt of $7.5 billion, AC’s interest expense ballooned.
While AC’s operating profit turned positive at $1.46 billion, interest expense and foreign exchange loss kept the net loss at $1.7 billion in 2022.
Is the worst over for the airline?
Oil price is starting to stabilize, as the rising interest rate is reducing demand. Air Canada expects an average exchange rate of $1.34 per U.S. dollar and an average jet fuel cost per litre of $1.09 ($1.3 in 2022) for 2023. It has revised its 2023 adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) guidance to $3.5-$4 billion (from $2-$3 billion).
The guidance hints that the worst is over for Air Canada, and there could be some improvement in profitability, as travel demand remains strong. But any change in fuel cost could significantly reduce EBITDA, as airlines spend 30% of their expenditure on fuel alone. Moreover, a possible recession poses a downside risk, as demand for leisure travel could take a hit.
Should you be worried about the airline’s debt?
I expect AC’s stock price to hover within the $20-$25 range till the volatility around the recession eases. The company is still vulnerable to the $7.5 billion net debt on its balance sheet, which would stress its net income. But the fear of bankruptcy has eased thanks to a 90% recovery in revenue.
AC has dealt with significant debt before. It has enough EBITDA to pay interest and smaller debt maturities and refinance bigger loans. It will take several years before the airline can reduce the debt to a comfortable level. But it can report net income in the coming three to five years on the back of strong revenue and improving efficiency.
Is now a good time to buy Air Canada stock?
In the 2009 Financial crisis, Air Canada’s stock recovered in two phases. In the first phase, the stock surged over 300% between April 2009 and November 2010 and then slumped 76%, losing all gains. In the second phase, the stock surged over 1,200% from June 2012 to June 2015, as restructuring improved AC’s efficiency.
After the pandemic crisis, Air Canada stock surged 100% (November 2020 to March 2021) on the back of pent-up demand. Now, it is entering the second phase of growth backed by improved efficiency. This growth could give significant returns as AC adjusts to its new world.
